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To hedge or not to hedge: for currencies, that’s not the only question

November 20, 2017

By: Mary Fjelstad, senior research analyst

Many US-based investors seek the benefits of diversification through a portfolio of international equities. Leaving the foreign exchange exposures of such a portfolio unhedged, however, creates an embedded currency basket of long positions in foreign currencies coupled with a 100% short position in the US dollar (USD).

As an example, the chart below shows the currency portfolio (from the US investor perspective) embedded in the FTSE Developed ex North America Index as of June 30, 2017.

An investment that has a short exposure has positive performance when the asset or underlying entity loses value. The opposite is also true: the short position will lose money when the underlying asset or position appreciates. A case in point: currency losses due to the short USD exposure in the unhedged FTSE Developed ex North America Index would have resulted in a -10.3% return in 2014 and -5.7% return in 2015, years during which the value of the dollar rose compared to other developed currencies.

What about the investor who is 100% hedged? When the value of the dollar falls, 100% hedging the embedded currency portfolio from international investments will incur foreign exchange losses. Both the unhedged and 100% hedged US international investor, then, are making a significant bet on the USD, and portfolio outcomes will be impacted.

So for the investor who seeks a neutral position on currency, what are the options? Some academic studies have supported a 50% hedge ratio for the following reasons:

it represents the neutral position as it is 50% short the base currency and 50% long[1]

it has been shown to minimize investor regret due to erroneous forecasts[2]

In 2015 FTSE Russell launched a series of five international equity indexes that apply a 50% hedge to the USD. A comparison of the performance of the FTSE Developed ex North America Index unhedged, 100% hedged and 50% hedged to the USD provides support for the claim that the 50% hedged index has displayed attractive asymmetrical risk characteristics. Moving to a 50% hedged index from the riskier (as measured by standard deviation) 0% hedged or 100% hedged index reduced risk by more than 50%.

During the period from January 2005 and June 2017, we can identify four states of the USD in relation to developed currencies:

USD decline from November 2005 - March 2008

USD slow strengthening from April 2011 - January 2014

USD surge from June 2014 - June 2015

USD trendless trading: there were notable spikes and declines in the dollar over the 24 months between June 2015 and June 2017, yet the USD value ended this period at the same level as it began

The chart below displays the volatility (as measured by annualized standard deviation of total returns) for the FTSE Developed ex North America Index, 0% hedged; 50% hedged; and 100 % hedged in these four market states as well as for the entire period. The chart shows that, in line with the observations of Gorman, Qian and Surz, index volatility was halved by moving to a 50% hedged position; in two cases, the volatility of the 50% hedged index was reduced almost exactly to the less risky level of the 0% hedged index. During the unusual second period–the “Falling Dollar”–when the 100% hedged index exhibited more volatility than the unhedged index, moving from that index to the 50% hedged index reduced volatility almost exactly to the less risky level of the 0% hedged index.

The FTSE 50% Hedged Index Series has been designed to assist investors in evaluating the currency exposures of their international equity investments.[4] Currency fluctuations are notoriously difficult to forecast. A 50% hedge ratio represents a neutral currency position; has been shown to minimize investor regret due to erroneous forecasts; and historically has exhibited attractive asymmetric risk characteristics.

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